Prosperity Watch Issue 54, No. 3: Significant shift in how businesses are structured has contributed to income inequality

The way in which businesses are structured has changed dramatically over the last 30 years. The growth of pass-through business entities accounts for much of the rise in income inequality over the last three decades, according to a new study. In the past, businesses typically structured as C-corporations – traditional corporations subject to the corporate income tax – and these corporations earned the vast majority of business income. This is no longer the case, the study finds. C-corporations now account for less than half of business income, with “pass-through” entities – businesses whose income is taxed at the owner level – growing rapidly.

Researchers estimate that if business income in 2011 had been earned along 1980 sector income shares, the country would have had an additional $100 billion in tax revenue to invest in infrastructure modernization and human capital development, for example. The report highlights a number of informative findings that have relevance regarding tax policy.

In 1980, C-corporations earned more than 75% of total business income. By 2011 they accounted for less than half of business income. Pass-through businesses, by contrast, now earn a majority of business income, whereas they earned only earned 20.7% of total business income in 1980.

Income generated from pass-through businesses structured as partnerships is taxed at the lowest average federal income tax rate (15.9%) among the major formal business sectors. This average tax rate is much lower than for the C-corporate sector (31.9%) and for the S-corporate sector (24.9%) in part due to capital gains and dividend income, which amount to nearly half of partnership income, being taxed at lower preferred tax rates.

Pass-through participation and pass-through income are especially concentrated among high-earners. Overall, 69% of pass-through income earned by individuals accrues to the top-1% of income earners.

Partnership ownership is not transparent. Nearly one-third of income earned in the partnership sector, $200 billion, could not be tracked back to the ultimate owners.

The shift in how businesses structure themselves is readily apparent in North Carolina. The number of businesses structuring as pass-through entities has increased significantly since 2003, while the number of C-corps has declined. Between 2003 and 2009, net gross receipts generated by partnerships in North Carolina increased by 81%.

The way in which businesses structure themselves has relevance for state level tax policy as well. In recent years, North Carolina lawmakers cut personal and corporate income tax rates significantly. These income tax cuts not only reduce available revenue, but also create a more upside-down state tax code. This latest research highlights how economic benefits accrued from businesses structured as pass-through entities largely flow to the wealthy, and that a flat personal income tax rate results in far less revenue. Accordingly, efforts to further reduce North Carolina’s personal income tax rate will continue to largely benefit the well-off in the state while low- and middle- income taxpayers see little to no benefit.